The Fed's "X" Factor

The most surprising element in last week's Federal Reserve (Fed) decision was not the announcement of Mortgage Backed Securities (MBS) purchases or the extension of its funds rate guidance to "mid-2015," both of which were signaled fairly clearly in advance. Rather, it was the fact that the aggressive monetary easing occurred alongside an upgrade to the central bank's economic forecasts. In their Summary of Economic Projections (SEP), Fed officials increased their forecasts for gross domestic product (GDP) growth for 2013 and 2014, lowered their expected path for the unemployment rate, and raised their forecasts for core inflation. Normally faster growth, lower unemployment and higher inflation would imply an earlier start to rate hikes. The fact that the FOMC pushed back the timing of rate hikes by half a year implies a shift in the Fed's reaction function: Fed officials now plan an easier path for policy even though the outlook has improved. This shift may indicate a move toward an "optimal control" approach for setting policy - an idea floated by Fed Vice Chair Janet Yellen earlier this year.

The change in the Fed's reaction function can be understood through the so-called Taylor Rule, a framework for setting monetary policy first proposed by Stanford University professor John Taylor. The Taylor Rule is often written as:

Where the inflation gap is the difference between actual inflation and the Fed's target (2% in the case of Personal Consumption Expenditures inflation), and the unemployment gap is the difference between the unemployment rate and the structural/natural rate of unemployment (which Fed officials currently peg at 5.6%).

The variable "X" is the key for the discussion here: this coefficient measures the degree to which the central bank responds to deviations in actual unemployment from its view of the natural unemployment rate. It can be thought of as a measure of how "activist" the central bank will be in addressing higher or lower than normal unemployment. In a sense, the Fed's latest actions can be thought of as increasing the value of "X": the committee has shifted to a more activist stance with respect to supporting the labor market.